CFA Institute

The Conglomerate Corporation Author(s): Neil H. Jacoby Reviewed work(s): Source: Financial Analysts Journal, Vol. 26, No. 3 (May - Jun., 1970), pp. 35-38+40-42+44-48 Published by: CFA Institute Stable URL: http://www.jstor.org/stable/4470677 . Accessed: 16/07/2012 17:13
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byNeil H. Jacoby

tTHE COG

OMRAT

THE

past decadehas witnessedthe thirdgreatwave

of corporate mergers in the American economy during the present century. Its dominant feature was the burgeoning of the conglomerate corporation. During 1968 more than forty-four hundred companies disappeared by mergers (including combinations and acquisitions) involving an estimated forty-three billion dollars' worth of securities - an all-time record. In this tidal wave of mergers, which may now have crested and begun to recede, conglomerate firms accounted for a substantial or a preponderant fraction of all firms and assets involved, depending upon the definition of "conglomerate." Why did a third merger wave peak in the nineteensixties and emphasize conglomeration? Is the conglomerate a stable and efficient form of business, the heir apparent to American corporate power? Or is it a financial fad, a source of monopoly, a threat to small business? Does it pose any new problems of public regulation? Is it monster or model of the future?

sources, product development,productiontechnology, or marketing channels.A "conglomerate merger" brings togethertwo or more such enterprises engagedin unrelated lines of business. It is a particular mode of enterprise growth in which the firm penetrates industries outside its currentoperations. Many managersof diversifiedfirms avoid use of the word, believingthat it denotes lack of any inner logic and has a pejorativering. They preferto describetheir companiesas "multi-market" or "multi-industry" firms. However, "tconglomerate" has gained too wide a currency to be discarded,and it is a special kind of multiindustryfirm. Modes of enterpriseexpansionmay be classified as follows: (1 ) Vertical (a) Backward(towardraw materialsources) (b) Forward (toward consumersof final products) (2) Horizontal (market extension within the same industry) (3) Productextension(into additional industries) (a) Producing relatedproducts (concentric) (b) Producingunrelatedproducts (conglomerate) Merger is a minor method of growth of American business corporations,the predominantsource being internally generated funds. Up to recent years most mergershave been of the verticalor horizontaltypes, in whichthe surviving firmsacquiredotherfirmswithinthe same industriesor industrialgroups. During the nine35

The Conglomerate Defined

"Conglomerate" is used herein to mean a business corporation producing products or services of several industries that are unrelated with respect to raw material
NEIL H. JACOBYis an Associate of the Center for the Study of Democratic Institutions; he is also Professor in the Graduate School of Business Administration at the University of California, Los Angeles, where he served as Dean during 1948-68. He was Chairman of President Nixon's recent Task Force on Economic Growth. This article i8 adapted from material which appeared in The Center Magazine, publication of The Center. FINANCIAL ANALYSTS JOURNAL / MAY-JUNE 1970

teen-sixties,however,most largemergersinvolvedfirms operating in different industries. Some encompassed firmsproducingproductsthat were relatedwith respect to sources of raw materials,productiontechnology,or marketing channels. These have been aptly termed "concentric" companies. Othersinvolvedunrelatedenterprises-the true conglomerates. are, of course, a matterof deProductrelationships gree, and opinions may differon whetherthose within a diversifiedcompany are significant. Spokesmenfor firmsoften offer tenuoustheoriesof cenmulti-industry trality to avoid the brand of conglomerate. Are such giantsas GeneralMotors(diesel locomotives, traditional refrigerators,and air-conditionersas well as motor vehicles) and GeneralElectric (jet engines and metallurgical chemicals as well as hundreds of electrical or concentrics?ShouldTransproducts)conglomerates americabe classed as a concentricbecause its avowed field is "services"'? Norton Simon, Inc., because it homeas a consumer, "servesthe needsof the individual becauseit is committedto maker,and person"?Bendi'x Or OccidentalPetroleum throughtechnology"? "growth and which describesitself as a "producer Corporation, processorof naturalresources"?Occidental,for example, rejects the conglomeratelabel because common oil, technologiesare used in exploringfor and producing all of naturalgas, coal, sulphur, and phosphates,and industrial enterinto fuels, fertilizers, these raw materials chemicals,and plastics,its majorproducts. On the otherhand, thereare manyhuge corporations that theirmanagements whose activitiesare so disparate do not even attemptto formulatea theoryof centrality. Among them are Litton Industries,which makes office sells packbuildsships,operatesrestaurants, equipment, aged foods, and operates national developmentplans, Inamong many other activities. Ling-Temco-Vought, ternationalTelephone and TelegraphCompany, Gulf and WesternIndustries,and Tenneco, Inc., are other conglomerateswhose manifold products clearly lack commonraw materials,productiontechnology,or marketingchannels. Even the namesof some conglomerates generality,such as National imply an all-encompassing Environment, CommonwealthUnited, or National General. aresometimes grouped companies Althoughconcentric to adopta strictdefiit is preferable with conglomerates, and nition,whichfocuses attentionupon the managerial financialeconomies that distinguishthe true conglomand has managerial The conglomerate eratecorporation. financialcontrolover productsso diversethat negligible economies of scale can be realized in performingthe producfunctionsof product-development, purchasing, tion, or marketing. Thus it differs from multi-plant,
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multi-product, or multi-industry firms that do achieve these economies. It differs, on the other hand, from the investment company, which does acquire ownership interests in firms producing unrelated products but does not have management and financial responsibility for them.

Lessons From the Past

We may more confidently assess the meaning of the current wave of conglomerations, predict its duration, and forecast the economic effects and public regulations it may produce by examining the course of past merger activity in the United States. Economic historians generally agree that the American economy has experienced three major business merger episodes since the eighteennineties. The first wave, in which activity rose markedly above its long-term trend during the five-year period of 1897 to 1902, peaked in 1899. In the peak year approximately twelve hundred mining and manufacturing corporations with total capitalizations of $2.3 billion (about ten billion in 1968 dollars) were involved. The major thrust of this wave was the joining of local and regional railroads into national systems and of one-plant manufacturing companies into national multi-plant entities. U. S. Steel Corporation, U. S. Rubber Company, and American Can Company were born in this epoch. The second episode, marked by a high level of activity during 1924-30, reached its peak in 1929. In that year some 1,250 mergers were reported, apparently involving securities of much larger total value than in 1899. Vertical and horizontal combinations of manufacturing, public utilities, and merchandising companies were prominent in this wave. The third period of hyperactivity began about 1965, when the graph of annual mergers broke sharply upward from its long-term trend line. Mergers continued to rise through 1968 when some twenty-five hundred mining and manufacturing companies were acquired with around twenty billion dollars' worth of securities. The most prominent actors in this wave were the conglomerates. The long-term curve of merger activity displays much peakedness. A four- or five-year buildup to a peak year of activity has been followed by a year or two of swift decline. In view of the anti-inflationary policies of the Nixon Administration and consequent leveling of stock prices, this pattern suggests that 1968 may turn out to mark the high point of the current wave, and that merger activity will subside during the next year or two to a "normal" level. If so, thirty-nine years would separate the second and third peaks, while thirty years separated the first and second peaks. Over the past seventy-five
FINANCIAL ANALYSTS JOURNAL / MAY-JUNE 1970

years, mergeractivityhas risen at a rate of under four per cent a year. Because this has been little more than the rate of growthof real G.N.P., mergeractivitydoes not appear to have become relativelymore important over the long term. Althoughmeasuresof mergeractivityare incomplete andone may not generalizeupon a basis of two or three that the hectic waves,the evidencesupportsa conjecture mergeractivityof 1968 will not be matchedagainfor a numberof years. The economyis probablynot moving seculartrend of businessconcentraup an accelerating should not be tion throughmerger,and conglomeration viewed in apocalypticterms. The forty-fourhundred by mergerduring thatdisappeared businesscorporations 1968 were a small numbercomparedwith the twelve thousandthat disappearedby failure, or the two hunformed.Even dredandseventhousandnewcorporations in securities exchangedin dollars billion forty-three the mergersthat year was less than four per cent of the marketvalue of corporatesecurities.

The conjectureis made that long-termmergerwaves in the UnitedStatesare explainedby the infrequent conof junctureof two preconditions:(1) an accumulation perceived and unexploitedprofit-making opportunities for enlargingthe scale of enterprises, arisingfrom basic technologicaland social changes, and (2) a buoyant capitalmarketwith strongdemandfor new securities. This Conjuncture Hypothesis,which is put forth as an interesting conjectureand not as a scientifictheory, combines elements of the "efficiency" and "stock promotion"theories. It assertsthat, before mergerhyperactivity can occur, there must be present both an unusually large number of opportunitiesfor enlarging profits by combining independent firms, and strong public demand for the new securities created in the do not mergerprocess. Becausethese two preconditions often coincidein time, mergerhyperactivity is much less frequentthan stock marketpeaks. The ConjunctureHypothesis reasons that the predominant motives for mergers are the drive of businessmen to realize larger profits by capitalizingupon Merger Episodes:An Hypothesis newly perceivedeconomies of scale, and the ability of Why has Americanmergeractivitytaken the historibankersto sell new securitiesto the publicon profitable cal form of a strong wave at long time intervals? We terms. It rejects the notion that monopoly power has closely know that mergerpeaks have not corresponded been an important motivefor corporatemergersduring commodityprices, or over-all with peaks in production, the past half century. The quest for monopoly power business activity. Of all economic indicators,merger apparently did play a role in the first mergerwave that activityhas been most closely relatedto movementsin laws were then peaked in 1899, becauseanti-monopoly industrialstock prices. A booming stock market has not vigorouslyenforced. Since WorldWar I, however, been presentat the crestof all mergerwaves. Yet a high the ShermanAct, the Federal Trade CommissionAct, all marketpeaks. level of mergershas not accompanied and state anti-monopoly laws have generallyforbidden In the extensiveliteratureon mergers,three theories combinationsthat threatenedto create undue market have been advanced to explain their motivation and power.The Conjuncture Hypothesisdoes not, of course, economiceffects. Manyobservershave seen in business imply that substantialadvantagesof larger scale are combinationsonly the eliminationof competitors,so necessarily presentin all mergers. Historydemonstrates that survivingfirmscan reap monopolyprofits. Others in that the hyper-enthusiasm of a stock market boom have stressedthe dominanceof promotersand bankers, many mergersare launchedthat later founder on the who engineered mergersin orderto sell securitiesto the rocks of reality. inflated prices.Stillothershave viewedmergers publicat Why does a combinationof a large numberof perto new opportunias a naturalresponseof businessmen ceivedopportunities for profitsfromenlargingfirmsand ties to reduce costs and expand sales and profits in a buoyantcapital marketsoccur infrequently?The idea competitiveenvironment.We may call these the "mothat changeis the only constantin modem society is by nopoly," the "stock promotion,"and the "efficiency" now a cliche. Less well understood is the distinctionbetheories. tween tactical (small, superficial)and strategic(salient, explanaNone, takenby itself, providesa satisfactory structural) changes. Most tactical changes cancel or tion of the long periods of time that have separated offset each other throughtime. A few cumulate into peaks of mergeractivity. There is no reason why the strategic shifts in the structure of technology and society. for monopolypowershouldmount questof businessmen Not only do strategic changes take many years to accomto a climax every thirty or forty years. Stock market plish but there is a time-lag between their occurrence and their general perception by people. Many strategic cycles have been much shorterthan a decade in their changes, growthand technological duration. Population changes create opportunities for profit by enlarging entake place more or which fatherbusinessopportunities, terprises. In the pervasive optimism of a stock market less continuously. boom, once-overlooked opportunities, or known opporFINANCIAL ANALYSTS JOURNAL / 1970 MAY-JUNE

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tunities previously not financeable, are acted upon. Given the rapidity of communication in financial markets, such perceptions multiply and build up to a climax. Wall Street goes through a phase of "merger madness." Later, the pool of profit-making opportunities for business combinations is drained. Concurrently, financial expectations deteriorate. Merger activity falls off as quickly as it previously mounted. Many years pass before structural changes in technology and society create a new pool of perceived chances for gains from enlarging the scale of corporate operations. When a new reservoir of opportunities has been filled, and this knowledge permeates the business and financial communities, the conjuncture of a boom in equity security prices will trigger another merger wave. Let us consider merger waves of the past. Certain structural changes set the stage for the first peak in 1899. One was the creation of a national railway network during the eighteen-eighties by the connection of hundreds of local and regional lines and the building of tens of thousands of miles of new lines. The same era witnessed the completion of national telegraphic and telephone communications. These facilities enormously reduced the cost and increased the speed of transportation and communication. National markets became a reality. By 1895 opportunities for profit by combining firms into larger units and reaping the benefits of lower costs through economies of scale in production had grown immensely. Meanwhile, the nation had developed a national capital market. By 1895 rising security prices had met the other necessary condition, and the first merger wave rolled on. That stock promotion gains may have played a significant role in this merger wave is suggested by the fact that a large number of the combinations made in that era subsequently failed. The structural changes that undergirded the second merger peak in the nineteen-twenties also took place in transportation and communication. With the development of reliable mass-produced motor vehicles and the completion of a national network of all-weather roads, the U. S. economy was motorized after World War I. Autos and trucks gave people and goods unparalleled mobility, enlarging markets, destroying local monopolies, and creating new economies of scale. Concurrently the home radio receiver made national advertising cheap and effective, built the value of national brand names, and enhanced the advantages of national marketing. Single-unit distribution was doomed. By the mid-twenties, businessmen generally perceived the astonishing opportunities for larger firms opened up by these changes. The booming stock market of 1921-29 satisfied the other precondition, and the second great merger episode was under way. Its economic rationale focused upon

economies of scale in marketing, although it also exploited production economies.

Structural Foundations of the Conglomerate Merger Wave of the Nineteen-Sixties

The Conjuncture Hypothesis is consistent with the main facts about the great merger wave still under way. Structuralchanges in the United States since World War II had by the early nineteen-sixties created a pool of perceived opportunities for profits by enlarging the scale and diversifying corporate operations. The buoyant capital market that emerged in the last half of the decade triggered the merger boom that began about 1965 by making it easy to sell new securities to the public. Most fundamental and powerful of the underlying structural changes was a revolution in management science. Other contributory factors were the postwar research-anddevelopment explosion, the rise of the service economy, a quantum increase in taxation, and a doubling of the price of capital.

Management Science and Computers

Radical changes occurred in the science of enterprise management after World War 11. These changes had their roots in the wartime efforts of mathematicians to solve complex logistical and military problems by "operations research." Concepts and methods were then developed that were later found to be equally powerful in dealing with the management problems of a civilian economy. Intuitive judgment has been progressively superseded by rational decision-making processes. Such problems as evaluation of investment projects, choice of financing plans, locating facilities, scheduling production and controlling inventories are now solved by mathematical and statistical methods. The concurrent phenomenal development of electronic computers has promoted and facilitated the expansion of management science. The computer not only does routine accounting with fantastic speed but performs the great volume of calculations involved in solving management problems. In 1950 only a few computers were operating in businesses; at the end of 1968 there were more than twenty thousand. This fundamental development has created opportunities for profits through mergers that remove assets from the inefficient control of old-fashioned managers and place them under men schooled in the new management science. Managers are able to control effectively a larger set of activities. Being of general applicability to business operations, management science makes possible reductions in financial and managerial costs and risks through acquisitions of firms in diverse industries. These gains differ markedly from the familiar economies of
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scale in production, purchasing, or marketing that normally accrue from mergers of firms with related products. Thus the new management science is the primary force behind conglomeration.

Quantum Leap in Taxation

A fourth factor underlying the current merger wave is the steep rise in the load of corporate-income taxation since World War 11. In 1940 the effective federal corporate income-tax rate was twenty-seven per cent; in 1968 it was fifty-three per cent, including the ten per cent surtax. Rates of state and local taxes on business incomes have risen commensurately. The manifold impacts of heavy income taxation on corporate policies can scarcely be exaggerated. They are a prime mover behind mergers. International oil and minerals companies with unused foreign tax-credits acquire companies whose incomes can be "sheltered" by those credits. American petroleum producers with large drilling expenses acquire high-profit firms for the same reason. Companies with profits merge with those having losses carried over from previous years that can be used to offset the profits. Many railroads found that diversification enabled them to use their past losses to reduce the tax liabilities of the companies they acquired. A central motive behind Container Corporation's union with Montgomery Ward to form Marcor was to defer payment for several years of more than sixty million dollars a year of federal income taxes by taking fuller advantage of Ward's ability to defer taxes on profits arising from installment credit sales. Equity securities of companies acquired in a merger are often replaced by convertible debentures of the surviving company, resulting in the replacement of taxable income paid out as dividends by tax-deductible interest. Also, debenture holders have been able to defer income taxes on their profits until the debentures are paid off. Tax avoidance is a powerful private motive for merger that puts a premium on conglomeration vis-a-vis vertical or horizontal combinations.

Research and Development Explosion

In the postwar era outlays on scientific research and development have grown nearly fourteen per cent a year, from $1.5 billion in 1946 to nearly twenty-four billion dollars in 1968. This dramatic increase in the national commitment to applied science and technology is a seminal factor in the evolution of the U. S. economy. By the nineteen-sixties it had created whole new industries-lasers, cryogenics, oceanography, electrooptics, xerography, and so on. It had generated thousands of new products in established industries - plastics, synthetic fibers, aircraft, electronic equipment, among others. Most important, it had evolved a proven method for deliberately creating commercially needed products through research. Research and development is now an established function of corporate business. Its economics call for organizations of considerable scale and specialization, which, in turn, require large sales volumes to keep down costs per unit. Also, research produces unexpected findings, and leads enterprises into diverse industries and product-lines. These are powerful motives behind mergers of the conglomerate type.

Rise of the Service Economy

During the past quarter of a century, the United States has been transformed from a "commodity" to a "service" economy. Most working Americans now produce services rather than tangible commodities. Whitecollar jobs outnumber blue-collar jobs. As real incomes have risen, and leisure time has expanded, a larger part of income is spent on personal and professional services, transportation, education, and recreation; a smaller part on food, clothing, and shelter. Established service industries like insurance, banking, consumer finance, medical care, air transport, television, motion pictures, and education have enormously enlarged their dimensions. Whole new service industries have come into being, such as computer leasing, auto rental, credit card and travel agencies. Data generation and processing aspects of service industries-which by definition serve masses of people - are especially large. Service industries have generally been in the forefront in computerizing their operations and using advanced management controls. It is no accident, therefore, that some of the largest conglomerates have specialized in services, including Transamerica, International Telephone and Telegraph, and National General.

Doubled Price of Capital

Since World War II the price of capital-the going rate of return to investors - has more than doubled. Medium-grade industrial bonds that yielded 3.3 per cent in 1945 returned 7.2 per cent in late 1968. Home mortgage loan rates went from four per cent to eight per cent in the same span of time. The dominant cause of the doubled price of capital can be expressed as a vast expansion of demand for investment funds in relation to the available supply. Expanding American research and development activities, the reconstruction and modernization of European economies, and the demands of less developed countries have combined to open up unprecedented demands for investment funds. Demand has tended to outrun available supply. Europe felt the sharpest impact of this imbalance and long offered higher
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retumsto investmentthandid the UnitedStates.During the mid-sixties the difference began to shrink by a markedrisein U. S. interestrates. Today,pricesof capital are aboutequalin the world'smajormoney-markets. The higher price of capital has had many consequences. Corporations have tried to use their capital

have promore efficiently.Cash management programs liferated. Investmentprojectshave been screenedmore rigorously. The financeofficerhas moved to the top of the corporatehierarchy. Aggressivemanagements have lookedfor mergerpartners ladenwith cash or liquifiable assets. Banks, insurance,and finance companieshave been especiallysoughtafteras acquisitions by industrial companiesbecause of their steady inflows of deposits, premiums,or loan repayments. Yet any companywith liquifiable andlow-earning assetshas been a target.Thus the pervasivequest for financialresourceshas been the motivebehindmany a conglomerate merger.

The game can continue until the public recognizes that there is no growthin the operatingearningsof the acquiredcompanies. The price of the conglomerate's stock then plummetsto a point wherethe price/earnings ratiois normal. At this muchlowerprice,furtheracquisitionsare unattractive andcease. Meanwhile, promoters will probablyhave unloadedtheir shareson less sophisticated investors,and bankerswill have pocketed their commissions. By assumptionthe mergersproduce no social benefits,so that all that happensis a transferof capital values from one to another set of individuals. Such "stock promotion"mergershave tended to take the form of conglomerationin recent years, because court decisionshave made other large mergersdifficult. Public policy can do little to prevent such mergers, beyondenforcingSecuritiesand ExchangeCommission regulations requiring full disclosureof all materialfacts.
If speculators ignore the rule caveat emptor, they suffer

Privateand Social Gains FromConglomeration

An explorationof the principalstructural changesin the U. S. economy that have fostered conglomerate mergers helps to identify the gains that may accrue from this kind of corporatediversification.A critical distinctionshould be drawn between social gains and private gains. Public policies should encourage,or at least permit,those mergersthat have the potentialityof yielding net gains to society. It should not encourage those that result only in transfersof wealth or income amongindividuals. The two principalkindsof privategain from mergers are promotionalprofits and reductionsin tax liability. While these private gains may or may not be accompaniedby social benefits,it is probablethat both result from most conglomerate mergers. Consider the extreme case of a merger whose sole purpose and effect is to generateprofitsfor promoters and bankers, who take advantageof the optimism of the public duringa stock marketboom. The standard gambitis to have a "growth" company,whose stock is selling at a high multipleof its annualearnings,acquire another company whose stock is evaluated at a low in the expectationthat aftera poolmultipleof earnings, ing of intereststhe marketwill value the equity of the expandedsurvivorat the highermultiple. In the atmosphereof a boom this expectationis often realized.Earnings per share of the acquiringfirm will increase as a result of the merger. The market will apply the high and bid up the price of the stock. This makes multiplier further acquisitionsthroughexchange of stock attractive. They are the basis of a furtherexpansion in reported earningsper share and further inflationof the marketprice of the stock.
FINANCIAL ANALYSTS JOURNAL / MAY-JUNE 1970

A good numberof the mergersduring the consequences. past waves have subsequently failed, implyinga want of real social gains. Of course, their promotersmay have sincerelybelievedthat real gainswere possible,but their hopes weredisappointed. Giventhe dynamism and complexity of business life, predictionsof social gains are inevitablyhazardous,and there is no feasible means of distinguishingpromoters with honest intentions from others. The public is best protectedby educationand full disclosure. The second type of privategain from mergersis reductionof tax liability. If a companywith carried-over losses is mergedinto a profitable company,the taxes of the survivorare reduced. Reductionin tax liabilityalso occurswhen a companywith fully depreciatedassets is acquiredon a purchasebasisfor a marketprice substantiallyin excess of net book value, therebypermitting the acquiring company to write off the acquired assets againsttaxes a second time. A furtherreductionarises if the companyacquired has littleor no debt outstanding andthe acquisition is financedlargelyor entirelythrough the issue of debt securities,the interestcost of which is tax deductible. When, for any or all of these reasons, taxes are reduced,government may be obligedto impose heavier taxes upon other firms in order to restore the preexistinglevel of revenues. There is a shift of tax burdenfrom stockholdersof the mergedcompaniesto those of the other firms. Society will be unaffected,exin the equity of the ceptingfor a possible deterioration tax system. Publicpolicy can do little to inhibitmergersarranged solely to cut taxes, given the high tax rates. Opportunities for reducingtaxes by mergercould be curtailedby radicalsimplification of the structure of federaltaxation of corporateincome. This structureis now highly dif41

ferentiated and shot through with special treatment of particular industries. Several types of gains from mergers are, at least potentially, of value to society. (a) Reduction of the risk/reward ratio. By definition, the conglomerate firm combines operations unrelated in respect to raw materials, technologies, or markets. The annual sales or profits of its different operations may be only weakly correlated. In the aggregate they will produce a more stable return through time. For any given rate of return on investment, risk will be less; for any given risk, expected reward will be higher. The standard gain from portfolio diversification will be realized. This benefits society as well as the conglomerate's stockholders, because the reduction in the premium for risk is equivalent to a cut in the company's costs and, via market competition, in the prices of its products. (b) Lower capital costs and avoidance of "Gambler's Ruin." Closely related to the gains of diversification are the advantages reaped by the conglomerate of lower capital costs and avoidance of "Gambler's Ruin." The conglomerate can raise funds on either a debt or equity basis at lower cost than could its constituents. In addition, having a "long purse," it is in a position to finance temporary operating losses of a subsidiary that would bankrupt the latter if it were an independent firm. The conglomerate is in a position to "out-spend, out-dare, and out-wait" smaller and financiallv less secure firms in its effort to win a market. This is socially beneficial, provided that the conglomerate continues to face adequate competition in its several markets-a subject to which we shall return. Of course, this same argument can apply to any large corporation-whether conglomerate or not. (c) Economies of scale in performing general management functions. Acquisitions can enable the conglomerate firm to apply over a wider sales base the talents of a skilled general management team. General management functions are involved, and include those of planning, organizing, staffing, budgeting, and controlling-generic functions in all kinds of enterprises. While organizational structures of conglomerates differ, the central corporate management commonly delegates wide authority to each divisional management, and holds the latter accountable for a "target" rate of return on the investment in its division. The central corporate officers enforce a planning and controlling discipline upon all divisional managers. They make the major decisions on capital allocation. Characteristically, they also provide a kind of "inside"'management consulting service to the entire organization.

(d) A cquisition of highly specialized management talent. Closely related to the third factor is the possibility that the conglomerate, with its larger and more diverse activities, can utilize efficiently specialized experts in operations analysis, computer science, behavioral science, incentive systems, international business, and so on. The scale of operations of the smaller firms it acquires is often too small to justify their cost. (e) Transfer of assets to more efficient management. A real social gain occurs when the assets of an enterprise are transferred via merger into the control of a superior management. Striking advances in management science, combined with great inequalities among firms in its application, have opened up extensive opportunities for gains from such transfers. Through more informed decisions and better information systems, resources can be deployed with greater efficiency, resulting in lower costs and product prices. While this kind of social gain can flow from any kind of merger, it is most likely in conglomeration. The reason is that market competition generally compresses differences in the quality of management of firms in the same industry to a smaller dimension than is present among firms in different industries. Hence the frequency and size of such gains from conglomerate mergers is probably greater. In what proportion of conglomerate mergers are social gains realized, and how large are those gains? Regrettably, these questions cannot be answered in the present state of knowledge. Answers would require intensive, elongated case studies of the costs, prices, profits, and managements of conglomerates and their constituents, before and after merger. Most conglomerate corporations have had too recent a life history to permit confident conclusions. Professor J. F. Weston analyzed the financial performance of fifty-eight multiindustry firms over the nine-year period 1958-66. As might be expected, their sales grew at an annual compound rate of 17.8 per cent a year, double that of all U. S. manufacturing firms. Earnings per share grew ten per cent a year versus 6.7 per cent for all firms in the Standard and Poor's stock index. Stock prices at each year's high point rose 10.5 per cent a year, against 5.4 per cent for the Dow Jones Industrial Average. In 1967 conglomerates earned 12.6 per cent on their net worth compared with 1 1.9 per cent for all manufacturingfirms. Prima facie, the conglomerates gave a superior performance. Yet, these figures do not prove that they managed assets more effectively than other corporations. Many of the firms in the Weston study were concentrics rather than true conglomerates. His study did not take into account the heavier levering of equity capital by conglomerate managements- a stratagem that is profitFINANCIAL ANALYSTS JOURNAL / 1970 MAY-JUNE

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able during strong business expansion, but which can managers backfireunderadversity. Also, conglomerate not infrequentlyintroducednew accountingpractices that inflatedtheir earnings. Empiricalproof of the frethus requency and size of gains from conglomeration mainsto be produced.

and Competition Conglomeration,Concentration,

The most importantissue of public policy raised by is its effect upon the vigor of competiconglomeration businessmergershave been identition. Traditionally, fied with tendenciesto monopoly. This is understandable, because most mergersin past years have been of the horizontalor vertical types. Many have increased percentageof the total -the industrialconcentration sales or outputof an industryaccountedfor by its leading four or eight firms. Economistsgenerallyagreethat betweenthe level thereis a positivebut loose correlation of concentrationof an industryand the probabilityof or oligopolisticbehaviorby its leading non-competitive of all outputof an infirms. When the preponderance dustryis producedby threeor four leadingcorporations, collusion amongthem is easier, or there may be a tacit mutualrecognitionthat all can profitfrom higherthan concentracompetitiveprices. As the level of industrial tion drops, the chances of non-competitivebehavior diminish and become negligible when the number of competingfirmsis morethantwenty. Proposedmergers of the sameindustry are therefore members of important for antiauthorities by the anti-trust properlyscrutinized competitive consequences,and are generally frowned upon. This is not to deny that there is vigorouscompetition in many highly concentratedindustries (i.e. automobiles),and that mergersof severalweak firmsin such industries may sometimescreatea strongenterprise able to offer sharpercompetitionto its rivals than did its components. A conglomerate mergerinvolves a union of firmsin differentindustries. It necessarilyleaves the ratios of unchanged.Conglomeraof all industries concentration tion does replace two or more smaller firms with one andthusmayincreasemacro-economic largerenterprise, of total industrial activity concentration-the percentage in the economyaccountedfor by the leadinghundredor two hundrednon-financialcorporations. Indeed, conglomerationby large firmsappearsto have held indusin the economyaboutconstant,while trialconcentration increasingmacro-economicconcentrationsince World War II. that is directit is industrial concentration Manifestly, Macro-economic of competition. to the vigor ly related concentrationneed not be of concern as long as the is largeenough corporations numberof giantdiversified
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to preclude overt or tacit collusion among them. Because it takes more than one hundred corporate giants to account for even a half of all manufacturing assets in the nation, we are far from the possibility of non-competitive behavior because of inadequate numbers. In general, conglomerate mergers are likely to invigorate competition. By strengtheningthe managerial and financial support available to each of its constituents, the conglomerate is able to make each a more energetic competitor in the industry in which it operates. Each entity can draw upon the conglomerate's pool of specialized managerial talent, utilize its management science, obtain financial assistance, and assume a more innovative and risk-taking posture than it could as an independent firm. Conglomeration can thus transform simple competition into multiple competition. Beyond this, the conglomerate is more likely to possess the financial and other resources needed to enter additional industries, theretofore closed to its smaller constituents. Established firms in those industries will, as a result, tend to behave more competitively than before in pricing their products in the hope of deterring the potential competition of the conglomerate. It has been aptly said that the conglomerate "sits on the edge of any and all markets," ready to enter, and thus keeps the Establishment on its toes. Indeed, a German economist has interpreted the conglomerate merger as a self-correcting force in American capitalism, making it more competitive and denying the Marxian prophecy of increasing monopoly. Certainly, enhanced potential as well as actual competition can be an important social gain. While conceding the probability that conglomeration energizes competition, many observers contend that large diversified corporations may engage in predatory or other kinds of conduct prejudicial to small firms. Several arguments are advanced. It is said that large conglomerate can engage in cutthroat or predatory pricing in one of its lines of business, subsidizing temporary losses from profits earned in other lines until its smaller competitors are driven from the field. In practice, instances of cross-subsidization are rare. Not only does it violate federal and state anti-monopoly laws but it flies in the face of accepted principles of management. In a multi-industry company it is not feasible to force the manager of one division or subsidiary to operate unprofitably when this requires abandonment of established targets and management incentive plans. Also, unless barriers to entry of new firms are very high, the subsidized division cannot reap monopoly profits once its competition has been eliminated, because its efforts to raise prices will attract new competitors and deny it an opportunity to recoup its losses.
FINANCIAL ANALYSTS JOURNAL / 1970 MAY-JUNE

Somewhatrelated to the "cross-subsidization" argument is the idea that the largefinancialresourcesof the conglomerate (its "deeppocket") enableit to engagein non-predatory but temporarily losing activities,such as expensiveproductdevelopmentor large-scaleadvertising thatsmallercompetitors are unableto finance,which ultimatelygive it the competitiveedge in the market. Whilethere may be truthto this contention,the advantage of the larger firm arises from superiorresources and not from conglomeration.Unless one believes that public policy should protect smallerfirms at any cost, one cannot object to product and marketdevelopment activities which are in the consumers' interest, even though they are open only to enterpriseswith ample financialmeans. Yet anotherstandard objectionto largefirms,whether or not conglomerate in nature,is that they achievesuch important advantages of scale thatthey raisethe barriers to entry into an industry. Here again there is truth in the argument. Conglomeration as well as other modes of businessdiversification can enable the survivingfirm to benefitfrom reductionsin risks or costs throughenlargement of operations. By increasing the stakesin the industrial game they make it harderfor poor playersto survive. If these economiesare real, society benefitsprovidedthat competitionremainseffectiveand obliges the conglomerateto pass the economies along to the public via lower prices or productimprovements.Few will defend the perpetuationof inefficientsmall-scale firmsat heavy cost to the public. What is importantis that a sufficient numberof firmsremainsin each industry to disciplineeach other. The possibilitythat the conglomerate firm will cause its constituents to practicecommercial reciprocity, to the disadvantageof its small competitors,is usually mentioned in assessingthe effectsof mergersupon competition. If intradivisional sales are made on competitive terms,therecan be no complaint.Is it realistic,however, to expectthe managerof one divisionof a conglomerate to do business with another division on unfavorable terms, countingupon recoupingthe loss by selling the other division some of his own product at higher than competitiveprices? The answeris negativebecause, as previously noted, it violates basic principles of management. Business reciprocitycan also be practiced in purchases and sales among different companies in such subtleways as to escape detectionby anti-trustauthorities. However, there is not clear evidence that conglomeratesare more culpable than other large firms. Corporatesystems of incentive and control normally delegateto divisionalmanagers the authority to buy and sell in the cheapestmarket.
FINANCIAL ANALYSTS JOURNAL / MAY-JUNE 1970

Finally,there is concernthat conglomeration may be of economicand a new route to dangerousaggregations political power in American society. A competitive democraticorder manifestlyrequiresan adequatedispersionof power. Citizensand lawmakers must remain vigilantto stop undueconcentrations of all kinds. It has frequentlybeen noted that over the sixteen-yearperiod of 1947-63 the top two hundredcorporations expanded their share of total value added in Americanmanufacturing from thirty to forty-one per cent, and that by 1963 the hundredlargestfirmshad a greatersharethan was held by the two hundredlargestin 1947. There are, nevertheless, reasonsfor believingthat macro-economic concentration is not at a dangerouslevel. Althoughreduced, the numberof large manufacturing corporations remainsso largeas to precludethe possibilityof oligopolistic behavior. Levels of industrialconcentration have not risen, and they are the relevantcriteriafor judging competition,as the 1964 guidelinespublished by the AttorneyGeneralrecognized. Americancourtshave consistently held that largesize is not, per se, an offense againstthe anti-trust laws. If corporate giantism were anti-social the government should long ago have proceededto break up the larger non-conglomerate giants. In a rankingof 130 members of the "billiondollar club" in descendingorder of their 1968 sales revenues,the five largestconglomerates were InternationalTelephone and Telegraph, 14th; LingTemco-Vought,30th; Tenneco, 45th; Litton, 48th; and Textron, 59th. If public policy requireda dismantling of these largest conglomerates,some fifty-four other giants should first be broken up. Only eight conglomeratesrankedamongthe two hundredlargestmanufacturingcorporations. Conglomeration helps to keep down industrialconcentrationin manufacturing and mining, in the face of risingmacro-economic concentration.For any assumed level of macro-economic concentration, a populationof will conglomerate firms producelower averageindustrial concentration thanwoulda population of single-industry or concentricfirms. This is shown by a simple hypotheticalexample: Americanmanufacturing is classified by the CensusBureauupon a basis of product-line into 470 "industries," which are aggregated into twenty-one "majormanufacturing groups." Let us arbitrarily-but not entirelyunrealistically-assumethat "industries" define competitive marketsin the sale of productsand that each "majormanufacturing group"embraces"related" products as the word is used herein. Assume further that macro-economic concentration rises greatlyto the pointthat all manufacturing activityis carriedon by five hundred giant corporations. What kind of corporate structure will minimize industrial concentration and
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maximize the probability of effective competition at the industrial level? There are three major alternatives: (a) A single-industry structure, under which there would be on the average about one firm in each of the 470 industries. (b) A concentric firm structure, under which there would be on the average about twenty-four firms in each of the twenty-one major manufacturing groups and 470 industries. (c) A conglomerate firm structure, under which all five hundred firms could conceivably compete in every one of the 470 industries. Under the assumed high level of macro-economic concentration, a single-industry structure would result in widespread monopoly. Even a concentric firm structure might leave some industries highly concentrated. Only a conglomerate firm structure would provide high assurance of effective competition.

Other PotentialEffects
Corporate conglomeration can have, at least potentially, important effects upon the role of internal financing of business, upon investment policies, upon the relationship of banking to industry, and upon the process of allocating investment among industries. Conglomeration tends to increase the role of internal financing of business enterprises by reducing the firm's reliance for funds upon external sources. In an industrially diversified firm, some divisions may be expected to have expanding needs for cash, while other less dynamic divisions may be throwing off cash. The aggregate demand for external funds by the conglomerate will fluctuate less through time than will the demand of an equally large but more highly specialized firm. Other things being equal, conglomerates will have less recourse upon the commercial banking system for short-term financing. Another likely, but still largely potential, consequence of conglomeration is a restructuringof investment portfolios. If a rising proportion of publicly owned corporations conglomerate, each incorporating the principle of portfolio diversification, managers of mutual funds, trust officers, and individual investors will find it less necessary to diversify their portfolios. Thus an investor might achieve the same protection against extreme fluctuations in the value of and income from his holdings by buying one million dollars' worth of stock in International Everything, Inc., as by buying fifty thousand dollars' worth of stock of companies in each of twenty industries. Another potential effect of conglomeration is to bring commercial banks and industrial corporations under

common control. Already, several industrial conglomerates have acquired commercial banks. The more popular route, however, is use of the "one-bank holding company" to acquire financial and industrial enterprises. A one-bank holding company is created when a sponsoring commercial bank issues stock of a new holding company to its shareholders in exchange for their present shares. The primary motive is to acquire a corporate vehicle able to diversify into financial services not open to commercial banks, such as computer leasing, credit cards, mortgage banking, or sale of mutual investment shares. Up to the end of 1968 some thirty-four of the nation's largest banks holding over one hundred billion dollars of deposits had formed such holding companies. Unlike chains or groups of banks controlled by bank holding companies, which are prohibited by the Bank Holding Company Act of 1951 from acquiring nonfinancial enterprises, one-bank holding companies are unregulated and able to enter non-banking activities. A serious potential consequence of conglomeration could be a worsening of resource allocation in the economy as a result of less accurate knowledge of returns to investment in different industries. Most conglomerates report their sales and net profits in the aggregate; they do not publish for investors the financial results of their operations in each industry or industrial group. The relative profitability of different lines being unknown, investors are unable to allocate their funds among industries with as much knowledge as they would possess in a non-conglomerate world. More and larger errors are likely to be made. Society will lose from a less efficient use of scarce capital.

Public Policy for Conglomerates

Should new types of public regulation be introduced to assure that conglomerate mergers, and the diversified corporations they create, serve the public interest? Let us briefly consider, in turn, public regulation of investment, of competition, of the relation between commercial banking and industry, and of financial disclosure.

Investment
During the current wave of conglomerate mergers unsound corporate marriages have been proposed, and some have been consummated by creating capital structures that are top-heavy with debt. Many of these mergers will fail to produce net gains. Some will ultimately fail. The question is naturally asked why government should not proscribe them. The answer is simply that there is no feasible way to identify socially functionless mergers in advance. Only time and the test of market competition will tell us ex post facto. A foundational concept of the American economic system is that busi1970 FINANCIAL ANALYSTS JOURNAL / MAY-JUNE

46

ness enterprisers should be free to try out new organizational patterns, management concepts, and financial structures, as well as new products. No governmental official can possibly know in advance which mergers will, and which will not, produce real benefits. To require advance decisions would be to deprive society of possible gains from innovation, and to substitute an autocratic judgment for a democratic decision by the market. The prevailing theory of regulation of investment properly asserts the right of each individual to deploy his funds as he wishes as long as there is full disclosure of all material facts necessary to an informed decision. While this policy costs society something in misallocated capital, the benefits are certainly worth the price. Analysis shows that there are valid and important social gains inherent in corporate diversification of the conglomerate type. The generic principle of conglomeration-a plurality of dissimilar activities within a large organization-finds expression in other American institutions. Public policy has not sought to limit or prevent this development. An example from the field of education is the contemporary "multiversity" with its diverse programs and professional schools. Labor unions also have "conglomerated," as when District 50 of the United Mine Workers sought to organize workers in diverse occupations under the aegis of a miners' union. Conglomeration has thrust into public consciousness knotty problems of the transference of corporate ownership and control. For example, are special restraints needed upon conglomerate acquisitions of such media of communication as radio and television broadcasting stations or publishing companies? Are they required for such instrumentalities of American foreign relations as international airlines? More generally, how can and should society guard against the use of multi-industry corporations by criminal elements to expand their economic influence? There are no easy answers to such questions, which need further study. Competition Because conglomerate mergers are more likely to increase - less likely to reduce - competition than are other forms of business combination, they do not call for changes in the anti-trust laws. The conglomerate corporation is neither a "monster" lacking in economic and social justification, nor is it a "model of the future" to which the U. S. economy will increasingly conform. Its present role in the private sector is modest, and is likely to continue so. It is an interesting new type of corporate structure within the vast and infinitely varied mosaic of American private enterprise. Under some circumstances it can yield real values for society. Whether
FINANCIAL ANALYSTS JOURNAL / MAY-JUNE 1970

these values are significant, and whether they will be realized in fact, only time will tell. The guidelines issued by the Anti-trust Division of the Department of Justice in 1966 make industrial concentration ratios the primary criterion for judging the competitive effect of a proposed merger. Conglomerate mergers do not change such ratios. The guidelines also place emphasis upon barriers to entry into an industry as a deterrent to competition. The conglomerate tends to strengthen the ability of its former constituents to surmount theretofore formidable barriers to entry into new industries. While it may also raise these barriers as against other small competitors, the net effect of the conglomerate is likely to be competitive. The Anti-trust Division should continue to study the impact of conglomeration upon competition. There is, however, no evident need for change in statutes or regulations.

Separation of Commercial Banking and Industry

The Banking Act of 1935 required American commercial banks to maintain an arm's length relationship with non-financial corporations. One purpose was to prevent banks from underwriting or holding corporate securities, which had contributed to the wave of bank failures after the stock market crash of 1929-32. A more important purpose was to maintain banking impartiality in supplying credit to businesses. A bank controlled by a conglomerate could be influenced to discriminate in favor of its parent's industrial subsidiaries and against outside enterprises in times of tight money and credit rationing. Member banks of the Federal Reserve System are instrumentalities for the execution of national monetary policies. As such, they should be independent of external influences that could create unfair competition. Therefore, federal legislation should be enacted to block the acquisition of commercial banks by conglomerate industrial firms. One-bank holding companies should be brought under the, Bank Holding Company Act of 1951, prohibiting them from engaging in non-financial activities.

Financial Disclosure
The conglomerate merger movement has thrown into bold relief preexisting faults in the current system of business accounting and financial reporting. It also created new problems. These defects should be cured in order that the business information system, upon which investors rely in allocating resources through the nation's capital markets, shall give accurate guidance. One serious fault is the lack of standard accounting rules and procedures. This permits opportunistic businessmen to vary reported profits within wide limits. A 47

corporate manager, for example, interested only in playing a numbers game with stock price/earnings ratios for quick profits, will seek to inflate current profits at the expense of future profits. The methods are legion. Shift from accelerated to straightline depreciation, defer or stretch out maintenance expense, deplete inventories held at low cost, sell assets for one-shot income. Excessive flexibility in permissible accounting methods creates opportunities for misleading changes in reported profits. As custodians of the business information system, the accounting profession should take the lead in correcting this condition. For purposes of efficient capital allocation, it is important to standardize accounting methods so that investors can easily compare the performance of firms within and among industries, and managers cannot as easily create profit illusions. The accounting profession should accord this need a top priority. The other problem is the information gap created by the loss of identity which acquired companies suffer in the published financial statements of diversified companies. Fortunately, all publicly held business corporations are now required by the Securities and Exchange Commission to report sales and net income for each industry in which they are operating. Difficulties in assigning taxes, interest charges, or overheads incurred by the corporation as a whole to divisions or subsidaries in particular industries may justify a report of operating earnings rather than of net profits. Some managers of diversified companies resist such reporting on the ground that it is costly, subject to error, and benefits their competitors. It is a sufficient answer, however, that just as they need this information for efficient management, so do investors need it for efficient investment. Regulatory authorities should also require publicly owned companies to state their earnings per share on a

"fully converted" as well as a conventional basis. The former basis assumes that all convertible securities are converted into common shares and that all warrants and options to purchase common shares are exercised. Only thus may the investor gauge the true contingent earnings of the company. This practice is especially needed by conglomerates, in the formation of which large amounts of warrants, options, and convertible securities were often issued.

Perspective
Although historical patterns suggest that the conglomerate merger wave of the nineteen-sixties may now be in a phase of recession, the true role of the multiindustry corporation in the American economy will not be known for another decade. If time and trial prove that its theoretical potential for lowering risk and raising returns on corporate capital are realizable, the conglomerate format will spread further over the corporate landscape. Should these values elude capture or be offset by faults yet unseen, many of these firms will disappear in a further restructuringof corporate power. Viewed in a broader perspective, the great wave of conglomeration attests to the flexibility and adaptability of the U. S. economy in response to underlying structural changes. It demonstrates that stockholder control of corporations continues to be a vital force. Stockholders are not the faceless and spineless figures depicted by some theorists, and managements ignore them at their peril. No institution of a democratic society should be above challenge. Managements of great corporations need to confront the contingency of take-over bids as a stimulus to unremittingexercise of skill, resourcefulness, and imagination. The conglomerate movement has, at least, shaken the corporate Establishment. *

FEDERAL
Inc. BOARD PAPER FEDERAL CO.,

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| Common

&Preferred Dividends:

MIDDLE SOUTH UTILITIES, INC. The Board of Directors has this day declared a dividend of 24d per share on the Common Stock, payable April 1, 1970, to . record stockholdersofofrecord at the close of business stockholders March 16, 1970. March 5, 1970 I ANNE M. FITZGERALD Secretary Secretary

~~~~~~~~~~~~~~~~~~~April ~~~~~~~~~~~~~May

The Board of Directors of Federal Paper Board Company, Inc. has this day declared the following quarterly dividends: 25 0 per share on Common Stock. 2854 per share on the 4.6% Cumulative Preferred Stock. The Common Stock dividend is payable on i5, I970 to stockholders of record at the close of business March 7, I970. The dividend on the 4.6% Cumulative $,5 par value Preferred Stock is payable on June i5, I970 to stockholders of record 29, I970.

THE MIDDLE SOUTH UTILITIES SYSTEM &Light Company Power Company Mississippi &Light Power Arkansas Public Service Inc. LightCompany New Orleans Power& Louisiana

J. KE QUENTIN
Montvale',Ne7wJersey

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